• SEC Adopts Amendments to the Definition of Accredited Investor
  • January 24, 2012 | Authors: Nicole A. Edmonds; Thomas M. Rose; Shona Smith
  • Law Firms: Troutman Sanders LLP - Washington Office ; Troutman Sanders LLP - Atlanta Office
  • On December 21, 2011, the U.S. Securities and Exchange Commission adopted final rules to amend the “accredited investor” definition in the rules under the U.S. Securities Act of 1933, as amended. This advisory explains the new definition of an “accredited investor” and what actions investors may need to take under the new rules.

    Section 413(a) of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act required the definition of “accredited investor” in the Securities Act rules to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of US$1,000,000. This change to the net worth standard was effective upon enactment by operation of the Dodd-Frank Act, but Section 413(a) also required the SEC to revise its Securities Act rules to conform to the new standard.

    Securities Act Rules 215 and 501, as amended, now define “accredited investor” to include, among other things, any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds US$1,000,000, excluding the value of the investor’s primary residence.

    As clarified by the SEC, an investor now has to exclude the positive equity of his primary residence from the calculation of net worth to determine if he is an accredited investor under such category. For example, if the fair market value of the primary residence is US$400,000 and the mortgage on that residence is US$350,000, then the positive equity is US$50,000. This is the amount the investor excludes from the calculation of net worth. However, if the mortgage exceeds the fair market value (for example, the mortgage is US$500,000 rather than US$350,000 in the previous example), then that difference of US$100,000 is reflected as a liability on the investor’s balance sheet.

    In addition, according to the final rules, if there is an increase in the amount of debt secured by an investor’s primary residence in the 60 days before the accredited investor determination is made (other than debt incurred in connection with the acquisition of a primary residence), then all such debt will be treated as a liability in the net worth calculation and will not be netted against the value of the residence. This provision eliminates investors’ ability to overstate their net worth for purposes of the accredited investor definition by taking on extra mortgage debt shortly before participating in an exempt offering.

    In cases where securities would be purchased based on an investment decision made before enactment of the Dodd-Frank Act, accredited investor status would have been determined at the time of the investment decision. A subsequent change in the investor’s accredited status would not be relevant.

    Therefore, the new rules also include a limited grandfathering clause for a person deemed an accredited investor under the previous definition and calculation of net worth who no longer qualifies.  If the investor (i) is purchasing securities pursuant to a right to purchase, (ii) qualified as an accredited investor on the basis of net worth at the time he acquired the right and (iii) both held securities of the issuer and had that right to purchase on July 20, 2010, then the investor may qualify as an accredited investor for the purpose of the follow-on investment using the previous rules for determining net worth.

    As a result of the new rules, investor questionnaires may need to be updated to reflect the new definition. Investors relying on the net worth category of the accredited investor definition may also need to get valuations of their residences to determine their fair market value and may also need to disclose the value of any mortgages thereon and the timing of when such mortgages were incurred in order to confirm accredited investor status.